On August 23, Federal Reserve Chair Jerome Powell delivered a speech at the annual conference of global central bank governors, which served as a formal acknowledgment that "the time for policy adjustment has arrived." This announcement has led financial experts and investors to predict a high likelihood of a rate cut by the Federal Reserve in September, marking the beginning of a new phase in monetary policyMoreover, with the Fed entering a potential easing cycle, the yield gap between Chinese and U.Sgovernment bonds—which had previously been inverted—could gradually narrow, thus supporting a potential recovery in the value of the Chinese Yuan against the U.SDollar.

It appears that the upcoming Fed rate cut might be more of a precautionary measure rather than an aggressive one

This, compounded with domestic issues in China such as a struggling real estate market and insufficient consumer demand, suggests that Chinese monetary policy might remain steady and relatively accommodative in the near futureUnder these circumstances, the question arises: Will the Yuan bounce back rapidly in the short term? Is there a possibility of a significant unilateral appreciation of the Yuan in the latter part of this year and early next year?

Firstly, it’s important to note that a rate cut by the Federal Reserve does not necessarily imply a significant weakening of the U.SDollar.

Since the 1990s, the Federal Reserve has enacted six notable cycles of rate cuts

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Among these, two were purely preventive, three were solely crisis-response rate cuts, while one was a mix of both strategies.

When observing the impacts of the two preventive rate cut phases, it becomes evident that their effects on the Dollar’s exchange rate were remarkably diverse—almost polar opposites.

During the first preventive rate cut cycle (July 1995 to January 1996), the U.SFederal Funds Rate was reduced from 6% to 5.25%, totaling a 75 basis points decline across three cutsSurprisingly, during this period, the U.SDollar index actually rose from 81.6 to 87.4. The unexpected strength of the Dollar at that time can largely be attributed to then-President Bill Clinton’s ambitious new economic strategy, which led to a rare fiscal surplus due to increased taxes and reduced deficits, alongside a burgeoning Internet economy and the subsequent stock market boom that attracted global capital into the U.S.

Conversely, the second preventive rate cut cycle in 1998 (September to November) saw the Federal Funds Rate decrease from 5.5% to 4.75%, again cutting by a total of 75 basis points

The Dollar, notably having strengthened for three consecutive years prior, faced a temporary setback, with the index falling from 100 to 96. However, once the rate cuts were concluded, a prolonged upward trend in the Dollar index resumed, culminating in a breakthrough surpassing 120 by early 2002.

From these patterns, we can draw several conclusionsFirst, the factors influencing the Dollar's value are multifaceted, with the Federal Reserve's monetary policy being just one component of a broader equationHence, the prospect of an aggressive devaluation of the Dollar is not guaranteed, and a counterintuitive strengthening can even occurSecond, given that the Dollar has already experienced an extensive strengthening period before any rate cuts, it does stand a higher chance of temporary weakness following the cuts

Third, in the case of short-term preventive rate cuts, the limited impact on the Dollar's trajectory is likely to yield modest resultsFinally, for prolonged periods of cuts, if the momentum for Dollar depreciation is eroded in the initial phases, there exists a risk of a rebound in the Dollar later on.

Looking ahead, geopolitical shifts and changes in domestic political leadership in the United States may rekindle a phase of appreciation for the Dollar indexPotential drivers could include a spike in U.STreasury yields, driven by fears about large-scale tax cuts and deregulation that could inflate the federal deficit; a shift in China-U.Srelations; fluctuations in the Euro, and continued geopolitical tensions globally that may spark fresh risk-averse behavior among investors, all of which could bolster the Dollar’s position.

Secondly, there arises a notable increase in the correlation between the Yuan and Dollar exchange rates.

Given that the Dollar remains the prevailing valuation, transaction, and reserve currency on a global scale, discussions about exchange rates are generally focused on the relationship between national currencies and the Dollar

While the exchange rates of currencies such as the Yuan shouldn't be simplistically viewed as reflections of the Dollar index, practical trends do indicate that fluctuations in the Dollar index significantly affect the Yuan.

To illustrate, the three major Yuan exchange rates against the Dollar—the central parity rate, the offshore rate, and the onshore rate—exhibit a degree of correlation with the Dollar indexPrior to March 2016, the relationship between the Yuan and the Dollar index was not particularly strong; however, by April 2016, their movements began to become more alignedSince 2019, the correlations of both offshore and onshore Yuan to Dollar rates have approached 0.7.

Moreover, the resonant relationship between the CFETS Yuan index and the Dollar index has increasingly strengthened

Essentially, while the Dollar index measures the currency's strength relative to a basket of foreign currencies, the CFETS Yuan index aggregates the weights of primary trading partners' currencies, thereby reflecting the Yuan's exchange level with major global currenciesDespite the differing weights assigned to various currencies in each index, correlation analysis shows a substantial increase in the correlation between the two indices, reaching 0.6935 from August 2023 to August 2024, and rising significantly to 0.9475 as of 2024.

In conclusion, the trajectory of the Dollar index, particularly under the context of Federal Reserve rate cuts, is likely to impact the Yuan’s exchange rateThat said, it's crucial to recognize that the Yuan's specific movements will be influenced by China's own economic growth and monetary policy stability.

Thirdly, the Yuan is likely to experience recovery and appreciation in the short term.

Within this rate cut cycle of the Federal Reserve, it's plausible to see a degree of recovery in the Yuan facilitated by the narrowing gap in yields between China and the U.S

Since the Federal Reserve began its rate hike cycle in March 2022, the disparity in yields for 10-year bonds between the two countries gradually inverted and expanded to a gap of 226 basis points by October 2023. However, with the Fed pausing its rate hikes, the gap narrowed to 122 basis points towards the end of last yearDespite anticipations of delayed rate cuts, geopolitical tensions have sustained demand for U.Sassets, affecting the yield disparity once again, broadening it to 243 basis points by late April this yearYet, expectations for rate cuts by the Fed have led to a gradual narrowing of the gap, now resting at 200 basis points by the end of July and further shrinking to 175 basis points by the end of August.

Contrarily, four key factors suggest that the potential for substantial appreciation of the Yuan in the short term is limited

Furthermore, the medium-term outlook for the Yuan against the Dollar may generally favor two-way fluctuations.

Firstly, the anticipated limited impact from the Fed's rate cuts could lead to continued fluctuation of the Dollar indexGiven the likely cumulative rate cuts ranging from 150 to 200 basis points—that would merely bridge the yield gap—while there may be temporary recovery for the Yuan, a substantial unilateral appreciation appears improbable in the short run.

Secondly, the previous back-and-forth exchange rate between the Yuan and the Dollar may have exhausted some upward appreciation expectationsSince the Fed entered its interest rate hike cycle in March 2022, the Dollar has consistently gained strength, while the Yuan depreciated from a rate of 1:6.4280 in April 2022 to 1:7.1839 in August 2023—a cumulative drop of 11.76%. Even so, compared to other non-U.S

currencies, this decline remains relatively modest with the Yen and Australian Dollar depreciating by 18.77% and 13.53%, respectivelyBeginning from September 2023, as the Federal Reserve's rate cut expectations have become more pronounced, the Yuan already appears to be entering a recovery path, albeit slowly moving from a midpoint of 7.1786 to 7.1216 by June 2024—a change of only 0.79%. This protracted competitive balancing has arguably tempered expectations for significant Yuan appreciation against the Dollar.

Thirdly, domestic monetary policy in China remains relatively loose, which may dampen upward momentum for the YuanHistorical trends during China’s own rate cut cycles (such as in 2012, and 2014-2015) often revealed a tendency for the Yuan to stabilize or even depreciate

The recently concluded meeting emphasized the importance of employing various monetary policy tools to ensure broad financial support for the real economy, potentially leading to effective reductions in financing costsIt’s anticipated that in the second half of this year through the second quarter of the next, Chinese monetary authorities might engage in policy interest rate reductions while employing measures like targeted reserve requirement ratio cuts and increased public debt issuance.

Finally, and perhaps most critically, the fundamental economic advantages that China holds have yet to be fully realizedPrevious strong appreciations of the Yuan against the Dollar coincided with robust growth phases in the Chinese economyHowever, the post-COVID recovery has been fragile, hindered by external factors like shifts in the U.S

and European supply chains, domestic demand challenges, and ongoing downtrends in the real estate sectorIn contrast, while the U.Seconomy has shown resilience with a quarterly GDP growth of 3.0% in Q2—much exceeding expectations—China's GDP growth slipped from 5.3% in Q1 to 4.7%, slightly underperforming market predictionsThis presents a significant challenge in capitalizing on the competitive edge of Yuan-denominated assets to attract foreign investments while hampering repatriation of U.SDollar assets by Chinese enterprises, which would limit the potential for substantial appreciation of the Yuan.

Ultimately, while the Fed's expected rate cuts may relieve the downward pressure exerted on the Yuan due to tight U.Smonetary policies over the past two years, a certain degree of appreciation of the Yuan is on the horizon